While the British pound plummets in value, the US dollar is flying high.
Against a tumultuous backdrop that includes the war in Ukraine, rising prices and China’s COVID lockdowns, sharp swings in some of the world’s major currencies are fueling new uncertainty in the global economic outlook.
Why is the British Pound in Free Fall?
On Monday, the pound plunged to a record low against the US dollar as investors rushed to sell the currency and government bonds in a major vote of no-confidence in new Prime Minister Liz Truss’s economic plans, including major tax cuts funded by steep hikes. in government loans.
The pound fell at one point in Asian trading to $1.0327, surpassing the previous record low of 1985 before regaining some of its value.
The price of 5-year British bonds – where investors lend money to the government in exchange for interest – fell sharply since at least 1991.
Under Chancellor of the Exchequer Kwasi Kwarteng’s “mini-budget” announced Friday, the UK is proposing its biggest tax cuts in 50 years, including abolishing the 45 percent tax rate on incomes over £150,000 ($162,000).
The tax cuts, along with a plan to support rising household energy bills, will require the government to borrow an additional £72 billion ($77.7 billion) over the next six months alone.
As with other goods and services, the value of most of the world’s major currencies operates on the principle of supply and demand.
When the demand for a particular currency is high, the price goes up and vice versa.
The pound’s plunging value indicates that investors are concerned about the UK’s ability to manage so much extra debt, especially as rising interest rates make borrowing much more expensive.
On Monday, Raphael Bostic, a top official at the US Fed, warned that the tax reform had “really increased uncertainty” and increased the risk of a global recession.
“Confidence in the British economy is low right now,” Pao-Lin Tien, an assistant professor of economics at George Washington University, told Al Jazeera.
“The new prime minister’s economic policy of cutting taxes on the rich is not too popular, and the consensus is that it will not work to stimulate the economy.”
While the UK’s tax plans were the first to trigger the pound’s free fall, economists say investor confidence in the UK economy has been waning for some time due to developments such as Brexit.
“The British pound has long suffered from political decisions in the UK,” Alexander Tziamalis, senior lecturer in economics at Sheffield Hallam University, told Al Jazeera.
“It has been hit by Brexit and also faces the prospect of a second Scottish independence referendum and a possible trade war with the EU over the Northern Ireland protocol.”
What can the UK do to halt the pound’s decline?
The main tool available to support the pound or any other declining currency is to raise interest rates to attract foreign investors with better returns on bonds and bank deposits.
On Monday, Andrew Bailey, the governor of the Bank of England, said the central bank would not hesitate to raise interest rates if necessary.
Despite calls for emergency measures from some economists, the Bank of England opted for an unplanned rate hike, pushing the pound to $1.06 after making some gains earlier.
“Both the Bank of England and the Bank of Japan may decide to raise interest rates to match rising US interest rates,” said Tien, the professor at George Washington University.
“This will help, but if investors don’t see enough aggressive action from the BoE or BoJ – meaning not just a hike in rates, but a bigger-than-expected hike in rates – it won’t help much with currency values. The problem with aggressively large rate hikes is that it will likely push the economy into a recession, which no one wants to see.”
Governments can also intervene by buying up their own currency to support its value, although this is frowned upon by many economies and there is a risk of trade sanctions being imposed.
“The pound and the yen are officially floating exchange rates, governments should not intervene often in the forex market,” Tien said.
Why is the US dollar so strong?
The strength of the US dollar, which has been on an upward trajectory since mid-2021 and reached a 20-year high against six major currencies last month, has two main drivers.
The first is confidence in the US economy relative to its competitors.
Similarly, a weakening currency reflects declining investor confidence in a country’s economy, a strengthening currency indicates confidence in the fundamentals of an economy.
While the US economy is battling high inflation and slowing growth, the dollar has long been viewed by investors as a reliable bet.
“The US dollar has always been seen as a safe haven for investors because the US is such a strong and large economy, so when there is global uncertainty it is always a safe bet to hold US dollars as they hold their value well. stay,” Ten said. .
“So with the war in Ukraine, economic and political problems in Europe, high inflation, etc., it’s not surprising that investors are turning to the US dollar.”
Marc Chandler, chief market strategist at financial advisory firm Bannockburn Global Forex, said the US seemed a safe bet for investors in light of global events, even if it posted negative growth over the past two quarters.
“The US’s biggest rivals have shot themselves in the foot. I am thinking of the Russian invasion of Ukraine and China’s zero-covid policy that has disrupted growth,” Chandler told Al Jazeera.
“The US allies also have serious problems. Japan is the only G10 country not to raise interest rates. China recently cut interest rates. Europe is on the brink of recession and the new UK government has fueled crisis talks with fiscal stimulus that widens the current account deficit.”
The second driving force behind the dollar’s gains has been interest rate hikes by the US Federal Reserve, which has raised the cost of borrowing in an attempt to curb rising inflation.
As depositors at US banks take advantage of interest rates, investors have been further encouraged to exchange other currencies for dollars, pushing the dollar’s price up.
“Of course, central banks in other jurisdictions, such as the UK, have also raised interest rates, and the eurozone plans to do the same. But they don’t act as aggressively as the US,” said Tziamalis, an economics professor at Sheffield Hallam University.
“Meanwhile, Japan is not tightening at all, so the net result is still greater overseas demand for dollars.”
Who are the winners and losers?
For US consumers, a stronger dollar means cheaper imported goods in stores and cheaper holidays abroad.
For everyone else, the picture is less rosy.
Not only does a stronger dollar mean more expensive US imports and travel in the US, it will likely exacerbate inflation in other countries in general.
Oil and other commodities such as metals and wood are usually traded in dollars, increasing costs in local currencies. Higher energy prices will in turn drive up the cost of other goods and services.
“The only exception is the US, where a stronger dollar makes it cheaper to import consumer products and could therefore help tame inflation,” Tziamalis said.
The strength of the dollar also makes it more difficult for many developing countries to repay their debts, which are often held in US currency.
“As a result, many countries will struggle to find an increasing amount of local currency to pay off their debts,” Tziamalis said.
“These countries will either have to tax their economies more, spend inflationary local money or simply borrow more. The results could be a deep recession, hyperinflation, a sovereign debt crisis, or all three, depending on the path chosen.”